Stop market order

A stop market order is an order to buy or sell a stock once the price reaches a specified level, known as the stop price. Once the stop price is reached, the stop market order becomes a market order and is executed at the next available price. This type of order is particularly useful for traders looking to limit losses or protect profits on an existing position.

How stop market orders work

Let's break down the mechanics of a stop market order with a practical example:

1. Setting the stop price: Suppose you have sold a call on SPX for 2 dollar. You decide that the max loss you want to risk is twice the premium you collected, in other words, 4 dollars. In this case you can set a stop market order 6 dollars.
2. Triggering the order: If the price of the call hits 6 dollars, your stop market order is triggered. 
3. Execution: Once the stop price is reached, the order becomes a market order, and the broker will buy back your call at the next available market price. 

It's important to note that the execution price may not be exactly $6. In a fast-moving market, the price at which the order is filled could be higher or lower due to market volatility and order execution speed.

Advantages of stop market orders

Automatic execution: The main advantage of a stop market order is that you are sure your position will be closed - as opposed to using a stop limit order. Stop market orders are executed automatically once the stop price is reached, allowing traders to manage their positions without constantly monitoring the market.

Disadvantages of stop market orders

Risk of bad fills: The biggest disadvantage is that you have no guarantee for which price your trade will be closed at. In highly volatile markets, the execution price may differ significantly from the stop price, potentially leading to unexpected outcomes. In 0DTE trading, this can be a significant risk if the market makes a sudden big move. 

You may also read:

• Stop-loss
• Stop limit order